NAFTA: Concept, Problems, Promise

by William J. Kehoe
O'Dell Professor of Commerce
McIntire School of Commerce
University of Virginia
Charlottesville, Virginia 22903, U.S.A.
Office: 804/924-7045
FAX: 804/924-7074
e-mail: [email protected]

Support for this research was provided by the McIntire School of Commerce,University of Virginia.

Presented at the Southern Marketing Association Conference, Orlando, November 11, 1995.

Published in Brian T. Engelland and Denise T. Smart, Marketing: Foundations For A Changing World. Evansville, IN: Southern Marketing Association, 1995. Pages 363-367.

NAFTA: Concept, Problems, Promise

Over the course of time and events, nations have sought ways to join with one another to advance their national and mutual economic interests. They have formed alliances, confederations, and trading blocs to free the flow of trade among member nations.

This manuscript's objective is to addresses alliance formation through an examination of the North American Free Trade Agreement (NAFTA). First, the concept of free trade is reviewed, as it is an underpinning to alliance formation. Then, the concept, the problems, and the promise of NAFTA are examined.

The frame of this manuscript is historic and its perspective is macro in nature. It examines the events prior to and concurrent with the passage of NAFTA. Not considered, given the historic frame, are the events after NAFTA's passage or the recent economic and political problems in Mexico, problems which, if manifested earlier, may have delayed or prevented the adoption of NAFTA.¹ Within the historic frame, the perspective of the examination of NAFTA is macro, not treating the more micro aspects of exchange between nations or how exchange relationships may differ given the disparate regions, industries, products, monetary systems, and consumers within each nation.

The Concept Of Free Trade

The premise of free trade is that an increase in the flow of goods and services across national boundaries will improve the average standard of living of people on both sides of a border. This belief is based in the law of comparative advantage which posits that, under free trade, people in each country will concentrate on producing or providing those things that can be produced or provided most effectively and inexpensively relative to other countries. As a result, gains in efficiency, in real income, and in Gross Domestic Product are expected in each country; costs are reduced because investment is spread over a larger market of all the countries in a trade agreement; and procedures, processes, and operations become more efficient due to international competition. These results of free trade between nations are posited to raise the standard of living in nations participating in a trade agreement. Such is the concept of free trade, the concept underpinning NAFTA, but also a concept debated and, at times, rejected by some economists, particularly those favoring multilateralism or multilaterally negotiated trade liberalization instead of free-trade agreements.²

NAFTA – The Concept

The North American trading bloc had its genesis in a free trade agreement between the United States and Canada. The U.S./Canada Free Trade Agreement produced a free trade area stretching from the Rio Grande to the Arctic Circle, the world's largest bilateral trade relationship, a U.S.$5 trillion economic bloc, ten percent larger than the economy of the United States and fifteen percent larger than that of the European Community.³

Origins Of NAFTA

While Canada and the U.S. were forging the U.S./Canada FTA, the government of Mexico was reforming its approach to international trade. The reform was motivated by the oil price collapse and foreign debt crisis that Mexico experienced in the early 1980's. As a result of these crises and internal economic malaise, the Mexican government reinvented its approach to the international economic community and joined the General Agreement on Tariffs and Trade (GATT).

Having joined GATT in 1986 during the administration of Mexican President Miguel de la Madrid Hurtado, Mexico was disposed to reduce trade barriers and comply with international trade standards.⁴ This orientation, combined with a program of economic reforms instituted by President Madrid's successor, Carlos Salinas de Gortari, reforms called "Salinastroika" by some managers in Mexico, made Mexico ready to join Canada and the U.S. in establishing a trade agreement.⁵

On August 12, 1992, Canada, Mexico, and the United States announced their intention to create a free trade zone – the North American Free Trade Agreement. Stretching from the Arctic Circle to Mexico's borders with Guatemala and Belize, NAFTA would be the largest trilateral trade relationship in the world.

Significance Of NAFTA

As the world's largest trilateral trade relationship, NAFTA is of profound economic and social consequence. It is a trading bloc of a size, wealth, and potential heretofore unknown in the world. The NAFTA countries are a massive combined market of 370 million people, with an estimated Gross Domestic Product of U.S.$6.2 trillion, compared to the European Community's 325 million people and estimated Gross Domestic Product of U.S.$4 trillion.⁶ The agreement elevates Mexico from a developing economy toward the level of a first-world economy and has implications for exports and job creation in the U.S.

The increase in exports and the number of jobs to be created by NAFTA was variously estimated. John Negroponte, a career foreign service officer, arguing that a first-world economy in Mexico was important for the U.S. wrote, "... nothing could be more desirable. A first-world market in Mexico signifies an exponential increase in U.S. exports and job creation. For every additional billion dollars the U.S. exports, 25,000 jobs are created."⁷ Dornbusch reported, "trade with Mexico in the past five years created almost 150,000 jobs that would not be there otherwise. An FTA (with Mexico) will bring more of the same."⁸ This view was confirmed in a prediction by the Institute for International Economics that NAFTA would bring a net gain of between 130,000 to 150,000 jobs over a five year period following its passage.⁹ Fortune magazine estimated NAFTA would bring the U.S. a net gain of "325,000 well-paying jobs by 1999."¹⁰

Beyond its economic significance, NAFTA has great social consequence. It demonstrates that the northern and southern hemispheres can "coexist in prosperity on the planet."¹¹ This is particularly important for such cooperation will ensure that the gap between rich and poor nations in the Americas does not widen.

Provisions of NAFTA

NAFTA combines the U.S. with its largest (Canada) and third largest (Mexico) trading partners. Trade between the three countries was well established prior to NAFTA and was embellished by the U.S./Canada Free Trade Agreement and an openness in Mexico that produced a near doubling of U.S./Mexican trade since 1988 "to $76 billion a year, with booming US exports accounting for much of the increase."¹²

NAFTA's provisions liberalize trade in the following ways:¹³

• Tariffs are either eliminated or phased out over periods of up to fifteen years. As much as 50% of U.S. exports to Mexico and 70% of Mexican exports to the U.S. became tariff/quota free on NAFTA's passage.

• Limits on investments are removed. Investors from any of the three countries are treated equally, currency is freely transferred at market rates, and performance requirements such as maintaining export levels and trade balancing are eliminated. Additionally, over the next seven to fifteen years, financial services institutions will be permitted to establish foreign-owned institutions and to invest in Mexican banks, insurance, and brokerage firms. Mexico will, however, continue to restrict certain land ownership by foreign nationals.

• Trade in services is liberalized and equal treatment is expected for service providers and professionals in each country. The countries are to facilitate the licensing of professionals and, by 1996, to eliminate citizenship and permanent residency requirements for professionals.

• Transportation regulations are liberalized. By the end of the decade, truck and bus operators will have almost unlimited access to the NAFTA countries.

• Protection of intellectual properties is strengthened. This includes protection of literary works, recordings, computer programs, and product and process patents.

NAFTA also provides various provisions to enhance the flow of trade among the three countries. Included is a trilateral trade commission to resolve disputes, provisions to review and prevent dumping of products across national markets, and procedures to allow a country to reinstate pre-NAFTA duties for a period up to three years, on a one-time only basis, if domestic industries are injured as a result of an import surge from another NAFTA country. While these safeguarding provisions are important, there may be little need to enact protection because much of the trade among the three countries is already tariff/quota free due to the U.S./Canada Free Trade Agreement and the trade reform and liberalization policies of former Mexican President Salinas.¹⁴

NAFTA: The Problems

It has been said that, "for a nation to prosper in the 21st century, it must be an active participant in the global economy and an open market for the world's goods. But with the lowering of trade restrictions comes economic hardship for some working Americans."¹⁵

Economic hardship and concomitant anxiety because NAFTA engenders a feeling among some people that "the U.S. is losing control over its economic destiny. NAFTA joined a big Third World country to the U.S. at a time when many Americans were losing their jobs and factories heading south of the border already. At the same time, companies that have been forced by U.S. environmental rules to spend millions on cleanup worry about competing with Mexico, with its hit or miss environmental regulations."¹⁶ All of these uncertainties, coupled with defense downsizing and economic restructuring accompanying the end of the cold war, exacerbates such potential economic hardships as worker displacement, the loss of jobs, the elimination of entire industries, as well as the environmental differences between the countries.

Problems Affecting Employment

At the root of NAFTA's potential negative impact on U.S. employment is the disparate wage rates between the U.S. and Mexico. Wages in Mexico are as low as U.S. 57 cents per hour for unskilled labor and an average of U.S. $3.80 per hour for skilled labor.¹⁷ Given these relatively low wages compared to U.S. standards, there is concern that jobs may flood to Mexico as the result of NAFTA and cause the following problems:

• Worker Displacement – Displacement occurs when a worker must acquire different, enhanced, or new skills in order to maintain a present job, or must secure a different job in his or her company. This may require retraining, sometimes at the worker's expense, extended periods of time between jobs, and possibly entering the new job at a level lower than the worker occupied at the previous job.

• Loss of Job – Job loss occurs when the employer is unable to compete in the international marketplace or enhances plant and equipment to compete more effectively, thereby necessitating fewer employees for the same productive operations. In short, the employee is discharged from the enterprise. This scenario may occur in those firms and industries that are labor intensive rather than capital intensive. Labor intensive enterprises may experience increasing difficulty competing against the relatively lower Mexican wage rates. Given this generalization, it is reasonable to conclude that firms in such labor-intensive industries as furniture, glass products, shoes, and textiles may experience loss of jobs to Mexico, while such capital intensive industries as chemicals, plastics, metals, pharmaceuticals, and telecommunications may be expected to fare well in the NAFTA era.¹⁸

• Loss of Industry – Industry loss occurs when firms are unable to compete with foreign competitors because of the lower cost structures of those competitors. In such situations, management may decide to close a firm or to relocate it from its home country to a foreign country and consider the investment in plant and equipment in the home country a sunk cost to be abandoned. That decision is made easier when the wage rates are lower in the foreign country; when health care cost and pensions are lower; the cost of capital is low; the foreign government provides a welcoming environment that may include favorable tax treatment or government arranged financing; the labor force in the foreign country is attractive, eager to work, well educated, or amenable to training; the foreign country offers a pleasant climate and an improving infrastructure; the foreign country's political and economic structures are stable; and the foreign country offers access, as in the case of Mexico, to a large and unsaturated market, and from Mexico, a gateway to the rest of Latin America. All of these things encourage the loss of industry and are the very real concerns for workers and unions in the United States.

Overlaid on the factors affecting employment are the effects of firm size and firm location. The smaller and the less advanced technologically a business, the less is its ability to compete in the NAFTA world. Likewise, geographic location may affect an enterprise's ability to compete under NAFTA.¹⁹ An assessment by the International Trade Commission found that the states in the U.S. southwest would benefit the most from NAFTA, while the midwest, the south, and parts of the west might experience economic disruption in the short run.²⁰ This conclusion is supported by a Economic Policy Institute study predicting significant job losses in the midwest. The state of Ohio, for example, is predicted to lose 406,667 jobs, 9.3% of jobs in the state, due to NAFTA.²¹

Problems Concerning The Environment

During the NAFTA debate, the U.S./Mexican border was called a "two-thousand mile Love Canal" because of the horrendous environmental conditions in the maquiladoras industrial zone along the border.²² There, open burning, open sewers, industrial runoff, and toxic dumping are the rule rather than the exception. Concomitant with these environmental abuses is the reported use of outdated technologies by the Mexican electric power industry in order to contain cost.²³

The lax environmental conditions along the U.S./Mexican border, coupled with lax environmental standards throughout Mexico, stimulated U.S. environmental groups to seek legal redress against NAFTA.²⁴ The result was a court order in June 1993 requiring the U.S. government to file an environmental impact statement on the potential effects of NAFTA.²⁵ The order was appealed by the Clinton administration on grounds of the environmental groups' legal standing to file the suite and on grounds that the ruling was an unconstitutional interference with the authority of the President. In reply, a U.S. Circuit Court of Appeals ruled that the NAFTA agreement was a Presidential action not reviewable by the courts, thereby voiding the order for an environmental impact statement and enabling the eventual passage of NAFTA.²⁶

NAFTA – The Promise

There is much that has been and is yet to be written about the promise of NAFTA. Hyperbolic may be a word to describe the arguments for and against NAFTA prior to its passage. Arguments that were reminiscent of the debate surrounding the formation of the European Community.²⁷ That debate is as yet ongoing in Europe. Arguably, even with the passage of NAFTA, the debate is still ongoing in the United States, especially given the recent economic and political problems in Mexico.

Increase In Jobs/Growth Of Industries

The strongest, if not the most histrionic, hyperbole in the NAFTA debate was the issue of the potential loss of jobs and industries due to NAFTA. Some jobs have been lost and will undoubtedly be lost because of NAFTA in both the U.S. and Mexico, particularly in labor-intensive industries. But, on balance, NAFTA is expected to produce a net gain in jobs.

One of the better analyses of the impact of NAFTA on U.S. industry is a study by Fortune magazine. That study presents a forecast for twelve U.S. industries following the passage of NAFTA and predicts an increase in exports by all twelve industries.²⁸ An increase in exports may be expected to bring an increase in jobs because "trade is a positive-sum game in which all parties stand to gain, and there is no natural limit to the number of jobs that can be created by it."²⁹ This does not, however, imply that there will be no loss of jobs in some companies and in some industries as the result of NAFTA.

Stability And Growth In Mexico

Passage of NAFTA was important for Mexico. It facilitated the continuation of economic and political reforms in Mexico. It was "America's best assurance that its large neighbor to the south will continue to develop into a stable and prosperous nation."³⁰

But, what would have happened to Mexico if NAFTA had not been adopted? Scenarios included a potential collapse of the Mexican economy, a reversal of economic and structural reforms, a run on the Mexican currency, a drying up of foreign investment in Mexico, and a nationalist backlash by the people of Mexico. Castaneda discounts the seriousness of these scenarios and suggests that the only downside to a defeat of NAFTA would have been damage to the prestige of former Mexican President Salinas.³¹ Interestingly, while NAFTA was passed, it has not prevented the recent damage to Salinas' prestige. Now, the new Mexican President, Ernesto Zedillo Ponce de Leon, needs a successful NAFTA to persuade voters that the pain of Salinas' economic reform program will have a payoff.³²

Protect And Stimulate U.S. Investment

Passage of NAFTA was important for the United States because U.S. firms had significant investments in Mexico. In August 1993, U.S. firms invested $615 million in Mexico; 72% of all foreign investment that month. In total, foreign investment in Mexico from 1989 through August 1993 was $33.09 billion, of which an estimated $24 billion was by U.S. firms.³³ The passage of NAFTA protected this investment, is expected to stimulate additional U.S. investment in Mexico, to provide additional markets for U.S. products, to increase jobs, and to enhance the standards of living in both the U.S. and Mexico.

Success with NAFTA will stimulate further investment in Mexico and provide a doorway to the rest of Latin America. That doorway may open toward an even larger trade agreement in the Americas, foreshadowing the mega-trading blocs that are likely to emerge throughout the world in the 21st century.³⁴ Theorists refer to a "triad concept" of the Americas, the Asia Pacific region, and Europe forming trading groups of the future.³⁵

Conclusion

NAFTA and the formation of other trading blocs around the world represent a paradigm shift in the way nations relate to each other through trade — a paradigm shift that recognizes the emergence of trade alliances in the global marketplace. It is a shift that cannot be ignored. The world is an interdependent place and agreements such as NAFTA will have economic, political, and social consequences of a scale not heretofore experienced.

Notes